The US stock market continues to soar despite extra volatility this summer, with equities up more than 17% for the year. Much of that powerful rally has been driven by big tech, which means dividend stocks (a longtime backbone of stock investing) continue to lag.
But amid an ongoing market rotation away from the stocks that have been the big winners, and with the Federal Reserve poised to lower interest rates, strategists say investors can still look to dividend stocks as a powerful generator of returns.
"Investing in dividend-paying stocks is a good way to participate in equities over the long term," says Dan Lefkovitz, a strategist for Morningstar Indexes. "There have been long stretches when the dividend-paying section of the market has outperformed," he says. "Eventually they'll come back into favor."
Even before then, investors can "mitigate some … risk by owning a dividend component," adds Joe Quinlan, a strategist for Merrill Lynch and Bank of America.
Why Have Dividend Stocks Underperformed?
The Morningstar US Market Index has returned 17.3% so far in 2024. Meanwhile, the Morningstar US High Dividend Yield Index, which includes stocks representing the higher-yielding half of the US dividend-paying universe, weighted by market cap, has returned 14.4%. The gap has persisted over the past five years, with two notable exceptions: the March 2020 market crash and the 2022 bear market.
Some of that difference in performance is due to the companies that pay dividends tending to be mature and defensive—such as financials, utilities, energy firms, consumer staples, and healthcare companies. Historically, big tech has been absent from that list. "The dividend-paying section of the market has been disadvantaged by its lack of technology exposure," explains Lefkovitz. “The action in the US equity market has been on the growth, 'dividend-light' side for 10-plus years."
More recently, rising rates have also helped keep dividend stocks down, according to Michael Clarfeld, who manages the Dividend Strategy portfolios at ClearBridge Investments. "As interest rates rose, people treated [dividend stocks] as bond proxies, and they underperformed."
Dividends Can Be Defensive
Over the past few months, market dynamics have been shifting. After a major pullback in August, big tech stocks no longer look unstoppable or expensive. Meanwhile, value stocks and high-quality companies with reliable balance sheets trading at lower multiples look much more interesting. Dividend stocks often overlap with this category. They tend to have reliable business models and cash flows that let them regularly return earnings to investors.
"Dividend-paying stocks have a value bias," says Lefkovitz. "To the extent that there's a rotation away from technology and growth into the value side of the market and more old economy sectors, that's going to benefit the dividend-paying portion of the market."
Strategists say that could be a boon to investors if there are more big stock swings. "We learned in early August that volatility … can spike dramatically and viciously," says Quinlan, who recommends dividend stocks as a core holding for investors because they can provide ballast for a portfolio and predictability during volatile periods.
New Dividend Stocks Join the Club
That doesn't mean dividend investors have to miss out on today's high-flying tech stocks. "It's not just for old industrials or financials" anymore, Quinlan says.
"It's easier to be a dividend investor than it used to be," adds Clarfeld. "A long time ago, technology companies didn't pay dividends." That's no longer the case.
Alphabet (GOOGL) and Meta Platforms (META) announced dividends this year, joining Broadcom (AVGO), Apple (APPL), Nvidia (NVDA), Salesforce (CRM), and a growing list of tech firms that return cash to investors in the form of regular dividend payments. Clarfeld acknowledges that the dividend yields on these stocks are still relatively low because of how high tech stock prices have climbed recently, but he adds that "they're going to compound powerfully over time."
Look Beyond Current Dividend Yield
For Clarfeld, long-term compounding makes dividend stocks an important pillar of balanced portfolios. He's a proponent of a dividend growth strategy, targeting companies that can sustainably increase their dividends over the long term. Rather than chase high yields in the short term, he recommends investors look to total return, which incorporates the reinvestment of dividends over time.
Quinlan agrees. "It's not just about the price," he says. "Total returns are hugely important."
Clarfeld says the average company in the portfolios he manages has compounded dividends at a rate of roughly 9% over the long term. At that rate, an investor's income would double every eight years. "It's not as fast as a quick run up in Nvidia, but over time, it works," he says. "It requires a bit of patience."
Dividend Stocks and Interest Rates
Investors believe the Fed is poised to cut interest rates in September, starting a new easing cycle after one of the most aggressive policy-tightening cycles in its history. The central bank began hiking rates in March 2022 as inflation soared, and rates have been at their current restrictive levels since July 2023.
Conventional wisdom says dividend investors should expect a boost as rates fall. Falling rates can push down bond yields, which can help make dividend yields more attractive in comparison. Firms with more debt also tend to benefit from falling rates and be in the dividend-paying category—think utility companies and REITs.
Rates aren't expected to return to the rock-bottom levels common over the past few years, but some have argued that an overall environment of higher interest rates will also benefit dividend investors.
Daniel Peris, a portfolio manager with Federated Hermes and the author of a recent book on the future of dividends, argues that price appreciation in the stock market will not be sufficient for investors searching for income in the coming years, which will force companies to increase payouts to compete with cash and bonds.
"That means more companies initiating dividends, more companies initiating dividends and companies making the dividends a more prominent part of the ownership proposition," he told Morningstar's The Long View podcast earlier this month.
Analysts also expect inflation to settle at relatively higher levels over the next few years compared with its unusual lows before the pandemic. Clarfeld explains that this will also help dividend stocks compete with fixed income, because investors could take advantage of corporate earnings growth via dividends, while fixed-income yields are just that—fixed.
Clarfeld says dividend investing comes down to making decisions based on analyzing company cash flows and their payouts to investors. "It's not a fad," he says. "It's the bedrock of investing."
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies
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